Bargained into a collective corner

State and local governments around the country are running out of money, have run out of money. Cuts are necessary, since raising taxes during an economic downturn is something akin to suicide. The natural place to look for cuts is bloat, where states have overspent.

And where is that, besides everywhere?

Well, spending bulged in the public employee payrolls. Not only do public employees tend to receive higher wages than comparable workers in the private sector, their benefit packages (lavish pensions, early retirement, lifetime medical care) have ballooned past rationality and appear, now, as unpayable.

While others debate the magnitude of the problem, and how to fix it, perhaps its worth the trouble to explain why it happened.

And for that, two concepts should help: Bilateral monopoly and the principal-agent problem.

Bilateral MonopolyWhen politicians and unions negotiate wages, both sides are monopolies of sorts. And the problem with this situation, called bilateral monopoly by economists, is that there is no obvious natural or equilibrium price for the services.

What do you pay workers?

Under competition — the rivalry for contracts, sales — bidders and askers in the market negotiate around until they settle on a stable price. When we say fair market price, we just mean the price that something (or some laborer at some task) would actually fetch on the market, in the context of competition.

But theres a whole range of prices possible when only two people are trading. The price could run up to as high as the buyer is willing to pay, and fall as low as the seller is willing to sell. That can be quite a range.

The public education sector is an an example of a bilateral monopoly market, says the Economy Professor website, because a government official negotiates with the representative of the teachers union.